13 Bankers: The Wall Street Takeover and the Next Financial Meltdown by Simon Johnson and James Kwak.
Johnson and Kwak's blog was essential reading during the financial crisis, and is still quite educational. This book is also required for Money & Banking in the fall. (I'm a bit sad because I went way over the Amazon clipping limit, so 314 of my highlights are invisible via the website.)
Johnson approaches the U.S. financial crisis from the point of view of a former Chief Economist of the IMF. That perspective allows him to see the irony of how the U.S. and the IMF advised East Asian countries through their financial crises in 1997-1998 compared to how the U.S. handled its own.
Related to my previous post, Johnson gives a history of banking and regulation in the U.S., from the first central bank charter of 1791 to Jacksonian populism, to the Panic of 1907 to the Great Recession. All of this is great, concise history.
Johnson comes down on the side of Thomas Jefferson--a distrust of centralized power of bankers as a threat to the Republic. He sees what the U.S. has now-- an oligarchy of a few large politically-influential financial institutions-- as little different from the cronyism of developing nations that the U.S. has been quite critical of. The U.S. advice to Asia in the 1990s was that no bank should be "too big to fail," and the big state-backed monopolies should be broken up. Johnson offers that same advice to the U.S. today-- find a way to break up the banks, just as Republican Teddy Roosevelt did with the Trusts of the early 1900s.
About 1/3 of this book is bibliography-- a treasure trove of sources and references. You always hear of the growth of finance, but it's nice to have specific data. The undeniable fact is that the deregulation of the financial sector in the 1970s and 80s did nothing to boost U.S. productivity and therefore did not result in an obvious better allocation of capital. The financial sector replaced manufacturing 1-for-1, and commercial & investment banking and insurance profits grew to be a much larger portion--almost 50%-- of all U.S. corporate profits by 2007. The amount of leverage taken on by financial sector firms became enormous over this time period:
"in 1978, all commercial banks together held $1.2 trillion of assets, equivalent to 53 percent of U.S. GDP. By the end of 2007, the commercial banking sector had grown to $11.8 trillion in assets, or 84 percent of U.S. GDP. But that was only a small part of the story. Securities broker-dealers (investment banks), including Salomon, grew from $33 billion in assets, or 1.4 percent of GDP, to $3.1 trillion in assets, or 22 percent of GDP. Asset-backed securities such as collateralized debt obligations (CDOs), which hardly existed in 1978, accounted for another $4.5 trillion in assets in 2007, or 32 percent of GDP.* All told, the debt held by the financial sector grew from $2.9 trillion, or 125 percent of GDP, in 1978 to over $36 trillion, or 259 percent of GDP, in 2007...In 1978, the financial sector borrowed $13 in the credit markets for every $100 borrowed by the real economy; by 2007, that had grown to $51.14 In other words, for the same amount of borrowing by households and nonfinancial companies, the amount of borrowing by financial institutions quadrupled....by the third quarter of 2009, financial sector profits were over six times their 1980 level, while nonfinancial sector profits were little more than double those of 1980."
The private sector began to wade where only the GSE's had tread before-- securitizing mortgages. Deregulation allowed the lines to blur between banks and non-banks, until the lines were at last removed in 1999. Greenspan and other regulators intentionally decided not to regulate various activities. For example, Greenspan declined to look at the books of mortgage brokers owned by bank holding companies-- even though it was in the Fed's realm to do so. If there were bad practices or "liar loans" piling up, he clearly said the problem would take care of itself (and later regretted his belief in market self-regulation).
The story is that of "bigger and better," following the textbook argument that this was well because insurance conglomerates merging with banking conglomerates merging with investment banks benefited from economies of scope and scale. Johnson, like Hayek, takes issue with this type of argument and offers some good rebuttal using various studies:
"The 2007 Geneva Report, 'International Financial Stability,'... found that the unprecedented consolidation in the financial sector...led to no significant efficiency gains, no economies of scale beyond a low threshold, and no evident economies of scope."
Basically, as banks got bigger they took on even more risk. As commercial banks and investment banks were increasing competition in the securitization game, firms began to engineer products in unique ways to differentiate their products. This caused problems of information asymmetries as very few people--including ratings agencies and the Federal Reserve-- understood the products being created. The banks could manipulate their creations to be rated well by certain risk models when actually they were quite risky. Ultimately, the taxpayer was put on the hook:
"(T)he special inspector general for TARP estimated a total potential support package of $23.7 trillion, or over 150 percent of U.S. GDP (as) theoretical potential liabilities of the government."
Johnson understands the difficulties of regulation, and while he advocated a Consumer Financial Protection Bureau, he understands regulations will do little good if banks know that they are too big to fail. He recommends that a commercial banks' assets be allowed to be no bigger than 2% of GDP, 4% for investment banks.
"Saying that we cannot break up our largest banks is saying that our economic futures depend on these six companies (some of which are in various states of ill health). That thought should frighten us into action."
I give this book 4 stars out of 5. Other reviewers have rightly noted that Wall Street isn't the only place where TBTF rules-- the government has been bailing out the auto industry for years, and various other industries ranging from steel to cotton are heavily subsidized and protected. But the sheer size of the banks, the growing percentage of U.S. GDP generated by finance, and the growing political influence of banks in our "revolving door" government is alarming.
While the book is pretty mistitled, Johnson does make it clear that we've not done much to ensure that a crisis like 2007 doesn't occur again.